12b - 1

Direct Method
Converting Cost of Goods Sold to Cash Basis

 Requires analysis of two accounts:

inventory and accounts payable.
 Can be computed as:

Cost of +or - changes in inventory

Goods Sold and
+ or - changes in accounts
payable

Cash payments
to suppliers
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12b - 2
Suppose CGS was $20,000; BI was $12,000 and EI was
$10,000; AP had a beginning balance of $13,000 and an
ending balance of $13,600. What was cash paid to
suppliers?

Inventory

Accounts Payable

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12b - 3
Suppose CGS was $20,000; BI was $12,000 and EI was
$10,000; AP had a beginning balance of $13,000 and an
ending balance of $13,600. What was cash paid to
suppliers?

Inventory
12,000

10,000
Accounts Payable
13,000

13,600
What increases and decreases each account??
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12b - 4
Suppose CGS was $20,000; BI was $12,000 and EI was
$10,000; AP had a beginning balance of $13,000 and an
ending balance of $13,600. What was cash paid to
suppliers?

Purchases Inventory
on credit CGS
12,000

10,000
Accounts Payable
13,000

13,600

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12b - 5
Suppose CGS was $20,000; BI was $12,000 and EI was
$10,000; AP had a beginning balance of $13,000 and an
ending balance of $13,600. What was cash paid to
suppliers?

Purchases Inventory
on credit CGS
12,000

10,000
Accounts Payable
Purchases
13,000 on credit

13,600

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12b - 6
Suppose CGS was $20,000; BI was $12,000 and EI was
$10,000; AP had a beginning balance of $13,000 and an
ending balance of $13,600. What was cash paid to
suppliers?

Purchases Inventory
on credit CGS
12,000
20,000

10,000
Accounts Payable
Purchases
13,000 on credit

13,600

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998

12b - 7
Suppose CGS was $20,000; BI was $12,000 and EI was
$10,000; AP had a beginning balance of $13,000 and an
ending balance of $13,600. What was cash paid to
suppliers?

Purchases Inventory
on credit CGS
12,000
20,000
18,000
10,000
Accounts Payable
Purchases
13,000 on credit
18,000

13,600

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998

12b - 8
Suppose CGS was $20,000; BI was $12,000 and EI was
$10,000; AP had a beginning balance of $13,000 and an
ending balance of $13,600. What was cash paid to
suppliers?

Purchases Inventory
on credit CGS
12,000
20,000
18,000
10,000
Accounts Payable
Purchases
13,000 on credit
17,400 18,000

13,600

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998

12b - 9

Direct Method
Converting Deferrals to Cash Basis

 Accounts like unearned revenue and prepaid

insurance may cause the cash received or
disbursed to be different than the revenue or
expense shown on the income statement.
 Cash for an expense can be computed
as:
Expense
Accrual Basis + or -
changes in Expense,
related PREPAID Cash Basis
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12b - 10

Direct Method
Example:
Suppose the Unearned Revenue account
showed a beginning balance of $200 and an
ending balance of $900. The income
statement indicates that $1,200 is the
amount of Revenue (earned) for the period.
How much cash was collected for revenue
(assuming A/R did not change)?
Unearned Revenue Revenue

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12b - 11

Direct Method
Example:
What is cash-basis revenue??
Unearned Revenue
200

900

Revenue
1,200

1,200

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12b - 12 Determine what causes increases and
decreases to each account, and find the
CASH!

Unearned Revenue
1200 200

900

Revenue
1200

1200

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12b - 13

Calculate the CASH!

Unearned Revenue
1200 200
1900
900

Revenue
1200

1200

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12b - 14

To summarize:
 What kinds of accounts need to
be examined to see if there is a
difference between our accrual
accounting records and actual
cash?

versus

General Ledger

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12b - 15

To summarize:
 Accounts Receivable
 Prepaids
 Inventory
 Accounts Payable
 Other Payables

All current assets and current liabilities

need to be examined in conjunction
with revenue and expense accounts.

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12b - 16

Indirect Method
 Net cash flows from operating activities
are determined by . . .
 Starting with net income, then . . .
 Adding and subtracting items that
reconcile net income to operating cash
flows.
 Requires an analysis of changes in all
current asset and current liability
accounts, except cash.
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12b - 17

Indirect Method
 Noncash additions to net income:
– Depreciation, depletion, and
amortization.
– All losses.
 Noncash deductions from net
income:
– All gains.

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12b - 18

T-account approach
 Set up a t-account for every balance
sheet account
– Put beginning and ending balances in the
accounts, using comparative balance
sheets
 Make the CASH T-account a BIG one,
with room for the three sections of the
Statement of Cash Flows

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998

12b - 19

T-account approach:
 Make every balance sheet
account balance, using the
income statement accounts to
calculate increases and
decreases to the accounts.
 When the cash number is
calculated for various increases
or decreases in balance sheet
accounts, put the appropriate
debit or credit in the big cash T-
account.
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998
12b - 20

Summary of Differences Between

Direct and Indirect Methods

 The direct method provides more detail about

cash from operating activities.
– Shows individual operating cash flows.
– Shows reconciliation of operating cash
flows to net income in a supplemental
schedule.
 The investing and financing sections for the
two methods are identical.
 Net cash flow is the same for both methods.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998

12b - 21

How important is the Statement

of Cash Flows?
 It is crucial to the presentation
of a complete picture of the
financial status of a business.
 Many businesses with great
ideas and potential have failed
due to their failure to manage
their cash flows.
 Remember, the statement is
REQUIRED by GAAP.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1998